State and Local Income Tax Deduction
The IRS allows taxpayers to claim a deduction for state and local income taxes in the year they are paid by completing Schedule A, Itemized Deductions, of Form 1040, U.S. Individual Income Tax Return. The value of all state and local income taxes paid is then added to all other itemized deductions and the aggregate value is used to reduce the amount of the taxpayer's taxable income and, thus, income tax.
When a taxpayer has claimed a federal itemized deduction for state or local income tax payments and subsequently receives a refund related to those payments, the Internal Revenue Code requires the taxpayer to report the refund as income on Form 1040 for the year in which the refund was received. As a result, only taxpayers who have filed federal itemized deductions for the year for which the state or local government issued a tax refund must claim the refund as income.
State and Local Sales Tax Deduction
To avoid the need to report any subsequent state or local income tax refunds as income, many taxpayers who itemize deductions will chose to claim a deduction for state and local sales tax instead of deducting state and local income taxes. Taxpayers may choose to deduct either state and local sales tax or income tax, but not both. Taxpayers who deduct state and local sales tax in lieu of income tax are not required to report any subsequent state and local income tax refunds as income.
State and local governments are required to report all income tax refunds to the IRS on Form 1099-G, Certain Government Payments. One copy is sent directly to the IRS, while a second copy is sent to the taxpayer who received the refund. Since the state or local government issuing Form 1099-G does not know whether the taxpayer is eligible to report the refund as income for federal tax purposes, any taxpayers with a refund of $10 or more will receive this form. Receipt of this form does not automatically mean the recipient must report the refund as income on federal Form 1040.